Target a venture capital partner
Choosing the right venture capital firms is an important part of the fundraising process. An entrepreneur who has not researched and targeted venture firms runs the risk of lengthening the search and overshopping the plan. Venture capitalists readily exchange information, so rejection from one firm may influence others.
The criteria for selecting the right venture capitalists to approach include their geographic and industry specialization, stage of company development, and size of investment preferences. Also important are whether the fund will act as a lead investor and whether there are complementary or competing companies within the fund’s portfolio.
The research of a fund’s preferences can be done by obtaining literature from the funds directly, talking to venture-backed entrepreneurs, visiting the PricewaterhouseCoopers MoneyTreeTM web site at www.pwcmoneytree.com, and by obtaining our quarterly nextwave publication -- a digest of ideas and investment trends for entreprenuers. You can also contact PricewaterhouseCoopers directly at 1-877-PwC-TICE. Our professionals are active in the venture community and welcome the opportunity to talk with you.
1. Profile of a typical venture capital fund
Professionally managed venture capital funds provide seed, startup and expansion financing as well as management/leveraged buyout financing. In addition to these distinctions, funds may also specialize in technology sectors such as life sciences -- while others invest in a wide array of technology and non-technology related arenas.
Venture capital firms are typically established as partnerships that invest the money of their limited partners. The limiteds are usually corporate pension funds, governments, individuals, foreign investors, corporations, insurance companies, endowment funds, and even other venture capital funds. When venture capital firms raise money from these sources, they group the committed money into a fund. A typical fund might close at $300-$500 million and actively invest for three to five years. Since investors in venture capital funds have specific return-on-investment requirements, a venture capitalist must evaluate potential investments with a similar return-on-investment consideration.
Since the return-on-investment is critical, venture capitalists invest with certain criteria in mind. Many funds invest between $6-$10 million in any one company over a three- to five-year period and look for companies with market potential of $75-$200 million. Since a venture fund typically invests in only 20-30 companies, each investment must be screened carefully. Venture capitalists will be looking for a 30 percent to 40 percent, or more, annual return-on-investment and for total return of 5 to 20 times their investment.
Venture capitalists are not passive investors and become involved as advisors to management, usually as members of the company’s board of directors. Venture capitalists seek to maximize their return by actively participating in their investments.
Just as venture capitalists perform due diligence, an entrepreneur must evaluate the benefits that a particular venture firm can provide the company.
Do the venture capitalists have experience with similar types of investments?
Do they take a highly active or passive management role?
Are there competing companies in their portfolio?
Are the personalities on both sides of the table compatible?
Does the firm have strong syndication ties with other venture firms for additional rounds of financing?
Can they help provide contacts for distribution channels and executive search?
2. The valuation process
It is critical for an entrepreneur seeking venture capital to assess the value of the company from the perspective of the venture capitalist and to appreciate the dynamics of the entrepreneur/ venture capitalist relationship. This relationship revolves around a trade-off. Funds for growth are exchanged for a share of ownership. The entrepreneur will be asked to give up a large share of ownership of the company, possibly a majority stake. The venture capitalist seeks to value the company to provide a return on investment commensurate with the risk taken.
Entrepreneurs seek to raise as much money as they can while giving up as little ownership as possible. Venture capitalists strive to maximize their
return-on-investment by putting in as little money as possible for the largest share of ownership. Through the negotiation process, the two parties come to agreement. Entrepreneurs understand that excess funding costs them equity. Venture capitalists must leave company founders with enough ownership to provide incentive to make the business succeed. To balance their individual goals, both parties should agree on one mutual goal—to grow a successful enterprise.
The first step in the negotiation process is to determine the current value of the company. The most important factor in determining this “premoney valuation” --or the value of the company prior to funding--is the stage of development. A business with no product revenues, little expense history, and an incomplete management team will usually receive a lower valuation than a company with revenue that is operating at a loss. This is because a company generating revenue has completed the R&D process for their product, thereby eliminating the greatest risk-- product failure in R&D. Each successive stage commands higher valuations as the business achieves milestones, confirms the ability of the management team, and progresses in reducing fundamental risks.
Stage I
Companies have no product revenues to date and little or no expense history, usually indicating an incomplete team with an idea, plan, and possibly some initial product development.
Stage II
Companies still have no product revenues, but some expense history suggesting product development is underway.
Stage III
Companies show product revenues, but they are still operating at a loss.
Stage IV
Companies have product revenues and are operating profitably.
The best way to build value in a company is to achieve the goals and milestones within the timeframes designated in the plan.
As milestones are achieved, risk is reduced and subsequent rounds of financing can usually be raised at more attractive valuations.
